Boston Fed research paper: The key variable for monetary policy is...

By Larry Doyle

Well, if we were to gather our news from USA Today or similar outlets, then I guess we could think just that.

Let's dig a little deeper.

What are many in and around the Federal Reserve likely reviewing in an attempt to gauge the real health of our employment situation?

I thank one of the single best individuals with whom I ever worked on Wall Street for sharing a paper released recently by the Federal Reserve Bank of Boston that addresses the fact that the 35-year low in the labor force participation rate — and not the unemployment rate — is truly the key variable in setting Fed policy. Is that right? Indeed it is.

We have not heard this take from Big Ben himself or other officials as they clearly subscribe to the "you can't handle the truth" approach in dealing with the American public.

The authors provide:

... compelling evidence that cyclical factors account for the bulk of the post-2007 decline in the U.S. labor force participation rate. We then proceed to formulate a stylized New Keynesian model in which labor force participation is essentially acyclical (i.e moves independent of the economy) during "normal times" (that is, in response to small or transitory shocks) but drops markedly in the wake of a large and persistent aggregate demand shock.

Finally, we show that these considerations can have potentially crucial implications for the design of monetary policy, especially under circumstances in which adjustments to the short-term interest rate are constrained by the zero lower bound.

The paper gets very technical in its delivery, but from what I have been told, it has attracted the attention of many within the Federal Reserve system. What do the authors conclude?

Overall, we view our paper as pointing out how labor market slack arising in the wake of deep recessions may not be well summarized by the unemployment rate (given the substantial lag in the response of participation), and consequentially, that monetary rules developed for the Great Moderation period may have to be adapted to account for broader measures of slack.

That is, they maintain that proper Fed policy is to stay exceptionally accommodative for a protracted period and run the risk of greater inflation to counteract the current underlying disinflationary trends within our economy.

So what are we to make of Bernanke's recent comments? I personally believe Ben is stretching the truth when he comments about an improving economy. I think he was — and still is — concerned with inflated asset valuations and wanted to let some air out of many of the market segments that had clearly bubbled.